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Homebuilders' Shares Don't Deserve Their Curb Appeal

(Bloomberg Gadfly) -- One of the sectors potentially most at risk from the Republican tax bill is housing. Investors, though, don't seem to have been home to get the message.

Increase in Dow Jones U.S. Select Home Builders Index in 2017

56%

The stocks of residential builders have been some of the market's best performers in 2017. The Dow Jones U.S. Select Home Builders Index is up 56 percent this year. And some stocks have done much better. Shares of $13 billion homebuilder NVR Inc. are up 109 percent since the beginning of the year. The stock of KB Home has climbed nearly 95 percent. The much-watched FANG stocks like Apple and Netflix are up a lowly 47 and 51 percent, respectively, by comparison.

What's more, the Wall Street analysts who rate the stocks don't share investors' enthusiasm. Among that crowd, the wariness for some of the biggest housing stocks has been near universal. For instance, not one of the 19 analysts who follow KB recommend the stock, and four say it's time to sell.

The details of the GOP tax bill are still in flux, and so its ultimate effects are unknown. But what is clear is that homebuilders and realtors have fought a key part of the House bill -- "full weapons-hot," the builders association has said -- which would limit how much mortgage interest can be deducted. On top of that, the tax bill will add to the deficit and, Republicans contend, bolster the economy. Both of those things should put more upward pressure on interest rates, which are already getting a push from the Federal Reserve, resulting in higher costs for a mortgage.

But the biggest problem could be demand. New-home sales slumped for years after the housing crisis. The reason, after credit became more available again, was a lack of household formation. Young people typically marry, have children and move into their first house. But that didn't happen, for whatever reason. (Some observers pointed to millennials living in their parents' basement.) But everyone ages, and the population grows, so housing market watchers have anticipated that household formation would spike to make up for the post-housing crisis stall. But while formation has ticked up, the hockey stick that was supposed to happen, and some think still will, hasn't. In fact, the most recent statistics show household formation slowing.

Longtime housing economist Thomas Lawler said high student loan debt, a historically low labor participation rate for younger workers and the Trump administration's stance on immigration would most likely continue to keep first-time homebuyers at bay. He predicts household formation could run 20 percent below the current consensus. Plus construction costs are on the rise because of tariffs on Canadian wood, and they are only expected to climb further as a labor force dependent on immigrant labor tightens. Lawler says he is baffled by so much enthusiasm for these stocks.

And there is plenty of enthusiasm. The median price-to-earnings ratio of the largest homebuilders based on next year's expected income is now 13, according to Bloomberg data. At the height of the housing bubble, the median P/E for the top homebuilders was 8.5.

The one thing working in homebuilders' favor during tax-cutting fervor is that they generally have high tax rates because most of their income is generated domestically. So the promised corporate tax cut to 20 percent would be a boon. But that still doesn't seem to justify the curb appeal for investors. KB Home, for instance, paid $36 million in federal taxes last year, after breaks, for a rate of 24 percent. The drop to 20 percent would add just $14 million to its bottom line, a boost of 8 percent. The rest of its expected 22 percent increase in profits in 2018 would have to come from an improvement in the housing business. Right now, it's unclear the foundations of the housing market are strong enough to deliver.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

To contact the author of this story: Stephen Gandel in New York at sgandel2@bloomberg.net.